14.54 International Trade Lecture 12: Specific Factors Model (II) - PowerPoint PPT Presentation

14.54 International Trade Lecture 12: Specific Factors Model (II) 14.54 Week 7 Fall 2016 14.54 (Week 7) Specific Factors Model (II) Fall 2016 1 / 24

Today’s Plan Refresher on Specific Factor Model 1 Effects of Changes in Factor Endowments 2 Factor Abundance and Comparative Advantage 3 Graphs on slides 4, 10, 11, 15, 16, and 18-22 are courtesy of Marc Melitz. Used with permission. 14.54 (Week 7) Specific Factors Model (II) Fall 2016 2 / 24

Main Assumptions The technologies for producing C and F are now represented by two production functions: Q C = F C ( K C , L C ) and Q F = F F ( K F , L F ) The capital allocated to each sector ( K C and K F ) is fixed The labor allocated to each sector ( L C and L F ) can change in response to outside shocks Subject to an aggregate endowment constraint: L = L C + L F where L is fixed 14.54 (Week 7) Specific Factors Model (II) Fall 2016 3 / 24

Determination of Factor Prices and Labor Allocation Factors (labor and capital) are paid the value of their marginal products Capital: r C = p C MPK C and r F = p F MPK F Labor: w = p C MPL C = p F MPL F Think of wage in terms of purchasing power in units of F : w / p F = MPL F = ( p C / p F ) MPL C 14.54 (Week 7) Specific Factors Model (II) Fall 2016 4 / 24

The Dutch Disease Courtesy of Skitterphoto. Image is in the public domain. 14.54 (Week 7) Specific Factors Model (II) Fall 2016 5 / 24

The Dutch Disease What’s Dutch about it? In 1959, the Netherlands found the largest natural gas field in Europe Why is it a disease? Expansion of commodity sector makes other sector, like manufacturing, less competitive If you think that manufacturing is too small, that is a disease 14.54 (Week 7) Specific Factors Model (II) Fall 2016 6 / 24

New Dutch Diseases? Fracking in the United States: Oil and Gas Endowments in 1960 Courtesy of Hunt Allcott and Dan Keniston. Used with permission. 14.54 (Week 7) Specific Factors Model (II) Fall 2016 7 / 24

New Dutch Diseases? Fracking in the United States: Oil and Gas Endowments Today Courtesy of Hunt Allcott and Dan Keniston. Used with permission. 14.54 (Week 7) Specific Factors Model (II) Fall 2016 8 / 24

New Dutch Diseases? It does not have to be oil! Image is in the public domain. 14.54 (Week 7) Specific Factors Model (II) Fall 2016 9 / 24

Changes in Factor Endowments What is the effect of factor accumulation on the welfare of all factors? Consider first the case of a small open economy (so p T unaffected by factor accumulation) Consider first an increase in a fixed factor ( K C for example) How are MPL curves affected? What happens to allocation of labor across sectors? 14.54 (Week 7) Specific Factors Model (II) Fall 2016 10 / 24

Changes in Factor Endowments What is the effect of factor accumulation on the welfare of all factors? Consider first the case of a small open economy (so p T unaffected by factor accumulation) Consider first an increase in a fixed factor ( K C for example) How are MPL curves affected? What happens to allocation of labor across sectors? 14.54 (Week 7) Specific Factors Model (II) Fall 2016 11 / 24

Effects of Kc Increase on Welfare What happens to welfare of workers? w / p F / and thus w / p C / since p C / p F → So the welfare of workers increases What happens to welfare of capital owners in F sector? r F / p F = MPK F � since L F � and thus r F / p C � So the welfare of capital owners in F decreases What happens to welfare of capital owners in C sector? r C / p C = MPK C Conflicting effect of L C / and K C / – which effect dominates? We know that MPL C / : this means that % ∆ K C > % ∆ L C Hence MPK C � and thus r C / p C � and r C / p F � So the welfare of capital owners in C decreases What would happen to welfare of all factors if productivity in C sector had increased ( MPL C and MPK C shift up) instead of K C increase? 14.54 (Week 7) Specific Factors Model (II) Fall 2016 12 / 24

Effects of Capital Accumulation or Productivity Increase for a Large Economy What would happen if this country were large enough to affect world prices? Capital accumulation in C or productivity increase in C will lead to growth biased towards C C / p T T What effect will this have on the world equilibrium trade price p F and the reallocation of labor and output between F and C ? T T and hence Q C / Q F and L C / L F / by less than when p / p � � C F T T p / p → C F What would be the consequences for the associated welfare effects? This price change improves welfare for capital owners in F and reduces welfare for capital owners in C 14.54 (Week 7) Specific Factors Model (II) Fall 2016 13 / 24

Who Favored Immigration in the United States? Capitalists, Landlords, or Labor Unions? Image is in the public domain. 14.54 (Week 7) Specific Factors Model (II) Fall 2016 14 / 24

Effects of an Increase in Labor Endowment Now consider an increase in the total labor endowment L What happens to the allocation of labor across sectors? 14.54 (Week 7) Specific Factors Model (II) Fall 2016 15 / 24

Effects of an Increase in Labor Endowment Now consider an increase in the total labor endowment L What happens to the allocation of labor across sectors? Some of additional labor goes to both sectors, so L C / and L F / 14.54 (Week 7) Specific Factors Model (II) Fall 2016 16 / 24

Effects of an Increase in Labor Endowment (Cont.) What happens to the welfare of workers? w / p C = MPL C and w / p F = MPL F since L F / and L C / � � � � So the welfare of workers falls What happens to the welfare of capital owners? r C / p C = MPK C / since L C / and r F / p F = MPK F / since L F / At a constant p / p , then r C / p F / and r F / p C / T T F C So the welfare of both capital owners increases In the 1920s , the U.S. imposed tight immigration restriction, largely because of labor unions 14.54 (Week 7) Specific Factors Model (II) Fall 2016 17 / 24

Proportional Accumulation of All Factors What happens to a country’s PPF if all factors increase by the same proportion? 14.54 (Week 7) Specific Factors Model (II) Fall 2016 18 / 24

Proportional Accumulation of All Factors What happens to a country’s PPF if all factors increase by the same proportion? Consider the production point on the new PPF where labor allocation is chosen such that L C and L F increase by same proportion as K C , K F , L Then Q C and Q F increase by this same proportion and MPL C and MPL F remain unchanged So this growth must be unbiased 14.54 (Week 7) Specific Factors Model (II) Fall 2016 19 / 24

Disproportionate Accumulation of Some Factors What happens to PPF and RS curve if K C increases proportionately more than K F and L ? Assume that K C / L / while K F / L → Growth will be biased towards C 14.54 (Week 7) Specific Factors Model (II) Fall 2016 20 / 24

Disproportionate Accumulation of Some Factors (Cont.) What happens to PPF and RS curve if K F increases proportionately more than K C and L ? Assume that K F / L / while K C / L → Growth will be biased towards F 14.54 (Week 7) Specific Factors Model (II) Fall 2016 21 / 24

The Relationship Between Factor Abundance and Comparative Advantage Now assume that there are 2 countries who share the same technologies (productions functions) but have differences in their relative endowments of factors such that: K ∗ K ∗ K C K F C ≥ ≤ F and L ∗ L ∗ L L What is the pattern of comparative advantage between these 2 countries? Home has a comparative advantage in C , Foreign in F 14.54 (Week 7) Specific Factors Model (II) Fall 2016 22 / 24

Specific Factor Model: Summary In sharp contrast to Ricardian model, the import competing sector does not ‘disappear’ when a country opens up to trade There is a very strong effect of changes in relative prices p T on the distribution of income and welfare across factors Even when countries share the same technologies, differences in factor abundance lead to differences in comparative advantage and hence aggregate gains from trade In the Ricardian model, there is no motive for trade if countries have the same technologies Improving the flexibility of factors across sectors mitigates the distributional consequences of trade Question for next chapter/topic: What happens when specific factor can be reallocated across sectors in the long run? Are we back to the Ricardian model? 14.54 (Week 7) Specific Factors Model (II) Fall 2016 23 / 24

MIT OpenCourseWare https://ocw.mit.edu 14.54 International Trade Fall 2016 For information about citing these materials or our Terms of Use, visit: https://ocw.mit.edu/terms.